SEC vs. Capital Gains · 2018. 8. 6. · I provide these comments from my perspective as an attorney-at-law (estate planning, taxation) for 32 years, a registered investment adviser

Ron A. Rhoades, JD, CFP® Director, Personal Financial Planning Program, and Asst. Professor - Finance

Gordon Ford College of Business, Western Kentucky University 1906 College Heights Blvd., Grise Hall #319

Bowling Green, KY 42101

Via electronic filing: [email protected]

August 6, 2018

Mr. Brent J. Fields Secretary U.S. Securities and Exchange Commission 100 F Street, NE Washington, DC 20549-1090

RE: File Number S7-09-18

Comment Letter #1: Proposed Interpretation of Fiduciary Duties Arising Under the Advisers Act

Dear Chair Clayton, Commissioners and Staff of the U.S. Securities and Exchange Commission:

As a researcher regarding the application of fiduciary law to the delivery of financial planning and investment advice, I submit these comments. This letter is submitted on my own behalf, and not on behalf of any organization, firm, or institution to which I belong or may be affiliated.

The content of this comment letter can be broken into the following major sections:

A. Responses to the 3 Main Questions Posed by the SEC: (1) Sufficiency of the SEC’s Guidance; (2) Omissions; and (3) Whether Codification Should Occur.

B. The Misinterpretation of SEC vs. Capital Gains: Disclosure is Not Sufficient to Satisfy A Fiduciary’s Obligations When a Conflict of Interest is Present

C. The Ineffectiveness of Disclosures: Compelling Academic Research Supports the Fiduciary Standard’s Application of the Fiduciary Duty of Loyalty

D. The Problem of Shedding the Fiduciary Hat: Dual Registrants

E. Correctly Applying the Fiduciary Standard of Conduct Requires an Understanding of the Important Public Policy Rationale that Supports the Application of Fiduciary Principles

F. The Interplay Of State Common Law and the Investment Advisers Act Of 1940 Imposing Fiduciary Duties on the Delivery Of Financial and Investment Advice

G. Edits to the Commission’s Interpretation of the Fiduciary Duties Arising Under the Investment Advisers Act of 1940

RON A. RHOADES, JD, CFP® - COMMENTS ON SEC’S PROPOSED INTERPRETATION OF FIDUCIARY STANDARDS OF CONDUCT FOR INVESTMENT ADVISERS 1

mailto:[email protected]

I provide these comments from my perspective as an attorney-at-law (estate planning, taxation) for 32 years, a registered investment adviser representative for 17 years, a participant in financial advisory association committees and boards and as a speaker at conferences and symposia and a researcher and commentator on fiduciary law as applied to financial services for over 14 years, and as a professor of finance and financial planning providing instruction in investments and financial planning for the past 6 years.1 I hope that this comment letter, which seeks to integrate the law and legal theory surrounding the fiduciary principle with practical application discerned from my many observations as to what actually occurs in the marketplace for financial and investment advice, will assist the Commission as it further considers its proposed interpretation.

A. Responses to the 3 Main Questions Posed by the SEC: (1) Sufficiency of the SEC’s Guidance; (2) Omissions; and (3) Whether Codification Should Occur.

Release #IA-4998 asks of commentators the following general questions, and I provide my general replies thereto.

(1) Does the Commission’s proposed interpretation offer sufficient guidance with respect to the fiduciary duty under section 206 of the Advisers Act?

In response to this first question, the SEC’s interpretation of the fiduciary standard of conduct, especially as it relates to how conflicts of interest are properly managed, appears to be based upon an incorrect interpretation and application of the SEC vs. Capital Gains2 decision on the key duties of a fiduciary financial and investment adviser when a conflict of interest is present. I set forth and explain the correct interpretation in a later section of this comment letter.3

I am also concerned that the SEC’s interpretation of the federal fiduciary standard of conduct, and in particular the processes that must be observed when a conflict of interest is present, fails to incorporate the guidance investment advisers require, which guidance can be discerned from state common law (which informs the federal fiduciary standard arising under the Advisers Act). In my edits to the Commission’s

1 I currently serve Director of the Personal Financial Planning program and assistant professor – finance, in the Gordon Ford College of Business at Western Kentucky University. I am also a state-registered investment adviser (Scholar Financial), serving a select group of clients with holistic financial and investment advice. I have previously served as Chief Compliance Officer and Chair of the Investment Committee of an SEC-registered investment advisory firm. I am also a member of The Florida Bar and currently serve select clients in estate planning and transfer tax planning matters. I served as Reporter for the Financial Planning Association’s Fiduciary Task Force (2006-7) and Standards of Conduct Task Force (2007), and I have held positions in various committees and boards within several financial planning organizations. I am also a member and former Chair of the Steering Committee of The Committee for the Fiduciary Standard ( www.thefiduciarystandard.org). I have written many articles regarding the fiduciary standard with the view of informing investment advisers of their duties, including blog posts at www.scholarfp.blogspot.com. Again, these comments are submitted on my own behalf and not on behalf of any organization, firm, or institution to which I may belong or with whom I may be affiliated. 2 Securities and Exchange Commission v. Capital Gains Research Bureau, Inc., et al., 375 U.S. 180 (1963) [herein referred to as “SEC vs. Capital Gains.” 3 See Section B, infra.


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proposed interpretation in a later section of this comment letter4 I provide language with additional suggested guidance.

In enacting the Advisers Act, Congress recognized that advisers are fiduciaries to their clients, but Congress did not create that duty. The fiduciary duties of investment advisers already existed, under state common law, and continue today. Indeed, the Commission has acknowledged that the Advisers Act incorporates common law principles.5

Should the Commission’s interpretations of the federal fiduciary standard diverge and be inconsistent with the consensus of state common law, such resulting inconsistencies could result in investment advisers becoming subject to liability if they may seek to rely only upon the Commission’s interpretation of their fiduciary obligations. It must be noted that the vast majority of claims6 brought against investment advisers are based not on the Advisers Act and the regulations promulgated thereunder, as the Investment

4 See Section G, infra. 5 In a settled enforcement action, Brandt, Kelly & Simmons, LLC, the Commission sued a registered adviser and its managing partner. The adviser negotiated with TD Waterhouse Investor Services (TDW) to move the adviser's client accounts from another broker-dealer to TDW. The adviser's managing partner told TDW that the other brokerage firm would charge the advisory clients a fee to terminate their accounts. To reimburse that fee, TDW offered to pay the adviser $ 7500 and the adviser agreed that it would use the money to reimburse clients. The adviser, however, did not tell clients about the reimbursement funds and used the money to cover operating expenses. When the SEC settled the case, it wrote that the adviser willfully violated sections 206(1) and (2) of the Advisers Act, "which incorporate common law principles of fiduciary duties." Thus, the Commission's view was that the fiduciary duty created by the Advisers Act encompassed state common law fiduciary obligations. Brandt, Kelly & Simmons, LLC, Admin. Proc. File No. 3-11672, 2004 WL 2108661 (SEC Sept. 21, 2004). 6 When an investment advisor breaches its fiduciary duty to its client, in addition to possible enforcement actions that might be brought by the Commission and/or by state securities regulators, the client may also possess a claim against their investment advisor based upon state common law fiduciary duties. The Senate Report accompanying the Private Securities Litigation Reform Act of 1995 (“PSLRA”) described the importance of private rights of action as follows:

The SEC enforcement program and the availability of private rights of action together provide a means for defrauded investors to recover damages and a powerful deterrent against violations of the securities laws. As noted by SEC Chairman Levitt, “private rights of action are not only fundamental to the success of our securities markets, they are an essential complement to the SEC’s own enforcement program.” [citation omitted]

See S. REP. NO. 104-98, at 8 (1995), reprinted in 1995 U.S.C.C.A.N. 679, 687; see also Basic Inc. v. Levinson, 485 U.S. 224, 230-32 (1988) (private cause of action is an “essential tool for enforcement of the 1934 Act’s requirements”).

Note, also, that preserves state authority in limited situations to bring antifraud enforcement actions. This savings clause retains state jurisdiction as follows: “Consistent with this section, the securities commission (or any agency or office performing like functions) of any State shall retain jurisdiction under the laws of such State to investigate and bring enforcement actions with respect to fraud or deceit, or unlawful conduct by a broker or dealer, in connection with securities or securities transactions.” 15 U.S.C. § 77(r)(c)(1).

The forum for such private claims depends on whether there is a forum selection clause in the investment advisor agreement between the investment advisor and client, and whether that arbitration clause has been negated by state law or regulation. As a result, court proceedings involving investment advisers may occur, arbitration before a panel such as the American Arbitration Association (“AAA”). Dual registrants’ arbitration occurs before FINRA’s arbitration panels.


Advisers Act of 1940 provides very limited private causes of action.7 Rather, breach of fiduciary duty claims against investment advisers are typically based upon state common law.8 Accordingly, maintaining consistency9 with state common law should be a major factor in how the federal fiduciary standard arising under the Advisers Act is applied. The interpretation of the fiduciary duties arising under the Advisers Act does not preempt,10 and should not seek to eclipse, state common law for breach of fiduciary duty by an investment adviser, given the limited remedies afforded to clients under the Advisers Act itself. Rather, the effect should be complementary.11

As the Commission’s application of the Advisers Act does not preempt most other federal laws nor state statutory and common law, the Commission’s interpretation of the investment adviser’s fiduciary duty only establishes a floor, and not a ceiling. Different or stricter fiduciary duties and more robust obligations of investment advisers might arise from other federal statutes (such as ERISA), state statutory laws and regulations promulgated thereunder, and state common law. While different sources of fiduciary law arise, the Commission should seek to conform to state common law (which informs the federal fiduciary standard), in order that the “floor” and the “ceiling” not become too distant. In other words, it is important that the Commission’s interpretation of the Advisers Act’s fiduciary standard of conduct be informed by, and be consistent with, the majority view of courts applying state common law standards.

7 In Transamerica Mortgage Advisors v. Lewis, 444 U.S. 11 (1979), the U.S. Supreme Court held that private plaintiffs are only able to sue their advisers under Section 215 of the Advisers Act. Section 215 provides that contracts made in violation of the Advisers Act, or the performance of which would violate the Advisers Act, are void. See Investment Advisers Act of 1940 § 215(b), 15 U.S.C. § 80b-15 (2018). 8 I acknowledge that SEC Release IA-4889 (2018) does provide, in the text of footnote 44: “Separate and apart from potential liability under the antifraud provisions of the Advisers Act enforceable by the Commission for breaches of fiduciary duty in the absence of full and fair disclosure, investment advisers may also wish to consider their potential liability to clients under state common law, which may vary from state to state.” I also acknowledge fn. 7 of IA-4889, stating: “This Release is intended to highlight the principles relevant to an adviser’s fiduciary duty. It is not, however, intended to be the exclusive resource for understanding these principles.” As stated, my concern is that the federal fiduciary duty, as related by the SEC, is inconsistent in several respects with state common law, as I discuss in more detail in the subsequent sections of this comment letter. 9 The Lockstep Doctrine, in which state courts follow the decisions of an inferior federal court as to an issue of federal law, illustrates (in reverse) the need for consistency. The doctrine is premised on the idea that one court will treat as binding another court’s interpretation of the law – not because it has to, but because of the benefits that such an approach generates. The federal law sees improvement. There exits better consistency in the application of the law. A higher quality in the adjudication of the law results. 10 Several provisions in NSMIA expressly avoid preempting or limiting a state’s ability to investigate and enforce its own anti-fraud laws. See, for example, Section 203A(b)(2) and Section 222(d) of the Advisers Act. See Zuri-Invest AG v. Natwest Fin., Inc., 177 F. Supp. 2d 189, 195 (S.D.N.Y. 2001) (National Securities Markets Improvement Act of 1996 (“NSMIA”) does not preempt state common law claims for fraud and conspiracy) (quoting Rice v. Santa Fe Elevator Corp., 331 U.S. 218, 230 (1947)). As the court stated, “legislative history indicates that it was the ‘[Commerce] Committee's intention not to alter, limit, expand, or otherwise affect in any way any State statutory or common law with respect to fraud or deceit . . . in connection with securities or securities transactions.’” Id., citing Conference Report, H.R. Conf. Rep. 104-864, 104th Congr. 2d Sess. At 34 (1996) (Emphasis added). Indeed, few statutes would possess such an “extraordinary pre-emptive power.” Id., quoting Metro. Life Ins. Co. v. Taylor, 481 U.S. 58, 65 (1987). 11 Nearly all of the leading legal theorists of the 20th Century generally agree that “the growth of the regulatory state should complement, not displace, common law.” Note, Common Law and Federalism in the Age of the Regulatory State, 92 Iowa L.Rev. 545, 556 (2007).


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The rationale for such conformity was stated recently by Chair Clayton: “[D]iffering standards confuse investors and may impose compliance costs on investment professionals.”12

In my suggested edits to the Commission’s interpretation, I set forth an interpretation of the federal fiduciary standard as properly informed by state common law. I suggest changes to the Commission’s interpretation in order to better adhere to common law fiduciary principle, to correct the Commission’s misapplication of language found in SEC vs. Capital Gains, and to provide more detailed and better guidance to investment advisers and their clients.

(2) Are there any significant issues related to an adviser’s fiduciary duty that the proposed interpretation has not addressed?

The Commission omits sufficient detail, as can be discerned from state common law and other sources, that effectively conveys the depth of the fiduciary’s obligations. In a latter section of this comment letter I provide edits and additions to the Commission’s interpretation, in order to bring the Commission’s interpretation into accord with state common law and as a means of providing more explicit guidance to both investment advisers and their clients.

A significant issue not addressed in the Commission’s proposed interpretation involves the requirement of reasonable compensation. While, due to time constraints imposed by the short comment period, I do not expressly address this requirement in this comment letter, if the Commission extends the time for submission of comments I will re-visit this issue during a future comment letter.

(3) Would it be beneficial for investors, advisers or broker-dealers for the Commission to codify any portion of our proposed interpretation of the fiduciary duty under section 206 of the Advisers Act?

I suggest that great caution must be taken in the codification of any principles-based standard. While the efforts of the Commission to educate and inform investment advisers, through its proposed interpretation, are helpful (although not entirely correct, as I discuss in detail herein), codification of the standard through further rule-making would be inappropriate.

Fiduciary duties are not static; rather, they must evolve13 over time to meet the ever-changing business practices of advisors and fraudulent conduct successfully circumscribed.

The need for evolution of the fiduciary standard of conduct has been known for well over a century. “Fraud is kaleidoscopic, infinite. Fraud being infinite and taking on protean form at will, were courts to cramp themselves by defining it with a hard and fast definition, their jurisdiction would be cunningly

12 Chair Jay Clayton, Speech, “The Evolving Market for Retail Investment Services and Forward-Looking Regulation — Adding Clarity and Investor Protection while Ensuring Access and Choice” (May 2, 2018). 13 As evidenced by the writings of Dean Roscoe Pound, in THE SPIRIT OF THE COMMON LAW (Transaction Publishers 1999) (1921), state common law is well-suited to a central role in the development and application of legal theories because of its unique ability to combine precedent and certainty with the power to change to meet new societal needs. Id. at 182. Likewise, in the 1930’s, as the role of statutes and administrative agencies grew larger, Dean James McCauley Landis pointed out the need for greater interdependence between administrative agency’s interpretations of the law and the common law. James M. Landis, Statutes and the Sources of Law, in HARVARD LEGAL ESSAYS, 213, 233 (1934).


circumvented at once by new schemes beyond the definition. Messieurs, the fraud-feasors, would like nothing half so well as for courts to say they would go thus far, and no further in its pursuit.”14

Because fraud is by its very nature boundless, the one fiduciary standard of conduct applicable to investment advisers should not be subjected to attempts to define or restrict it legislatively, or by rule-making, by means of any particular definition. As observed in an early speech from the Commission’s legal counsel to its Corporate Finance division:

Like fraud, abuse of trust is not a fact but a conclusion to be drawn from facts. The terms ‘gross abuse of trust’ or ‘gross misconduct’ should not be limited by any hard and fast definition. Both constitute fraud in its general sense … the interpretation of gross misconduct and gross abuse of trust as used in Section 36 will depend not only upon relevant common law principles but also upon the declaration of policy as set forth in the Act ….15 [Emphasis added.]

Breach of fiduciary duty is constructive fraud, to which the same principle applies.

Moreover, the Commission’s interpretations, if codified, may become outdated over time as innovations occur in the investment advisory industry. Should codification occur of the federal fiduciary standard, over time the Commission could be prohibited from taking action against practices that would violate common law fiduciary standards applicable to investment advisers.

Should codification occur, then the Commission, without continually reviewing and revising its own regulations, could also be subjected to claims that defeat enforcement actions on the grounds of indeterminacy or vagueness. The vagueness doctrine, as articulated by the U.S. Supreme Court, requires that a penal statute define offenses with sufficient clarity so that an ordinary person can understand what conduct is prohibited, and so that the statute does not lead to arbitrary or discriminatory enforcement.16

The Commission should also seek to preserve the flexibility of state common law, as such state common law continues to inform the Advisers Act and the federal fiduciary standard. As the delivery of investment advice evolves over time, courts implementing the common law fiduciary duty can respond to such changes, and to particular facts and circumstances, and thereby continue to develop the fiduciary obligations of investment advisers. Under state common law, the courts may draw fiduciary principles

14 Stonemets v. Head, 248 Mo. 243, 154 SW 108 (1913) (Judge Lamb, writing for the Missouri Supreme Court). See also Justice Douglas’s majority opinion in Pepper v. Litton, 308 U.S. 295, 311 (1939), wherein he stated: “He who is in such a fiduciary position cannot serve himself first and his cestuis second … He cannot use his power for his personal advantage and to the detriment of [the cestuis], no matter how absolute in terms that power may be and no matter how meticulous he is to satisfy technical requirements. For that power is at all times subject to the equitable limitation that it may not be exercised for the aggrandizement, preference, or advantage of the fiduciary to the exclusion or detriment of the cestuis. Where there is a violation of those principles, equity will undo the wrong or intervene to prevent its consummation … Otherwise, the fiduciary duties … would go for naught: exploitation would become a substitute for justice; and equity would be perverted as an instrument for approving what it was designed to thwart.” 15 Speech, “Diversiform Dishonesty” by Edward H. Cashion, Counsel to the Corporation Finance Division, U.S. Securities and Exchange Commission, on November 17, 1945 to the National Association of Securities Commissioners, where in reference to Section 36 of the Investment Company Act of 1940. 16 United States v. Williams, 553 U.S. 285, 304 (2008); Kolender v. Lawson, 461 U.S. 352, 357 (1983).


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from tort law, agency law,17 or trust law, each of which contains its own set of requirements with respect to fiduciary obligation.

Furthermore, by not seeking to “codify” the principles-based18 fiduciary standard as a set of more specific rules, the Commission preserves its own ability to adapt to insights from financial economics research affecting investment advisory practices, to insights from behavioral economics, and to innovations occurring within the investment advisory industry itself. The beauty of a principles-based standard lies in its ability to guide actors subject to it, regardless of the new business models or practices or greater use of technology that might emerge in the future as the financial services industry continues to evolve over time.

B. The Misinterpretation of SEC vs. Capital Gains: Disclosure is Not Sufficient to Satisfy A Fiduciary’s Obligations, When a Conflict of Interest is Present

Commentators often opine that the U.S. Supreme Court approved, in its 1963 SEC vs. Capital Gains decision, of “disclosure” as the sole means of satisfying a fiduciary’s duty of loyalty, when a conflict of interest of present. But, such commentators choose to ignore these words in the decision – which cannot be ignored:

It is arguable -- indeed it was argued by ‘some investment counsel representatives’ who testified before the Commission -- that any ‘trading by investment counselors for their own account in securities in which their clients were interested . . .’ creates a potential conflict of interest which must be eliminated. We need not go that far in this case, since here the Commission seeks only disclosure of a conflict of interests ….”19 [Emphasis added.] [Emphasis added.]

These words, contained in the SEC vs. Capital Gains decision, are often ignored by commentators, most of whom are employed either directly or indirectly by broker-dealer firms20 and hence, it may be assumed,

17 I would opine that agency law should not, however, be seen as the primary source for the application of the fiduciary standards of conduct for investment advisers. Unlike the investment adviser-client relationship, in a principal-agent relationship the principal usually possesses control over the agent. In the investment adviser-client relationship it is the fiduciary (investment adviser) who usually possesses (or should possess, as an expert, in order to adhere to her or his fiduciary obligations) a great deal of knowledge regarding the workings of the capital markets. It could be stated that sources of developed fiduciary law that are more analogous to the investment adviser-client relationship could be looked at for guidance, such as the law concerning attorneys and their clients, or (with some limitation, given differences in both the standard of due care and the “sole interest” duty of loyalty) ERISA. 18 The Commission has acknowledged that the Advisers Act is a “principles-based” regulatory regime, rather than one based upon rules. In 2008, the Director of the SEC’s Division of Investment Management, who is responsible for implementation of the provisions of the Investment Advisers Act, noted, for example: “When enacting the Investment Advisers Act of 1940, Congress recognized the diversity of advisory relationships and through a principles-based statute provided them great flexibility, with the overriding obligation of fiduciary responsibility.” Andrew J. Donohue, Dir., Div. of Inv. Mgmt., U.S. Sec. & Exch. Comm’n, Keynote Address at the 9th Annual International Conference on Private Investment Funds (Mar. 10, 2008), available at http://www.sec.gov/news/speech/2008/spch031008adj.htm. 19 SEC vs. Capital Gains, at text accompanying note 48. 20 Many broker-dealer firms (and dual registrant firms) seek to avoid restrictions upon their business practices, and the fiduciary standard of conduct – properly applied in accordance with common law principles - is perhaps the


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are engaged in what can only be considered “wishful thinking.” Yet, their desired interpretation of the decision – that all that is required when a conflict of interest is present is disclosure of the conflict, followed by “mere” (not “informed”) consent – has no foundation in the law. The words of the U.S. Supreme Court – “in this case” and “we need not go that far … since here the Commission seeks only disclosure of a conflict of interests” – show the Court’s judicial restraint only. The U.S. Supreme Court’s holding was to apply a federal fiduciary standard to the conduct at issue; the Court was not called upon to delineate the many requirements imposed upon investment advisers as a result of such federal fiduciary standard.

It must be understood that in the SEC vs. Capital Gains enforcement action, where the Commission sought injunctive relief, the Commission only sought a breach of the fiduciary duty for the adviser’s failure to disclose. This limited nature of the enforcement action by the Commission is understandable. Failure to disclose a conflict of interest, when present, is clearly a violation of the fiduciary duty of loyalty. Proof of failure to disclose is easy to provide. In contrast, other requirements that exist (as are set forth in more detail in my edits to the proposed interpretation, set forth later herein, and specially as to the requirements of informed consent and continued substantive fairness), often require expert testimony, greatly complicating and making more expensive enforcement actions.

The 1933 Securities Act and the Securities and Exchange Act of 1934 both adopt a “full disclosure” regime as a protection for individual investors. But, as made clear by the U.S. Supreme Court, the Investment Advisers Act of 1940 goes further. It recognizes the long-standing understanding that the fiduciary standard exists because disclosure is inadequate as a means of consumer protection in situations in which there is a great disparity in power or knowledge.

Previous actions involving the application of the Advisers Act’s fiduciary standard of conduct support the proper interpretation that disclosure, in and of itself, does not negate a fiduciary’s duties to his or her client. The Commission long disagreed with the notion that all that is required to satisfy one’s fiduciary obligations, when a conflict of interest is present, is “disclosure” and “consent”:

We do not agree that “an investment adviser may have interests in a transaction and that his fiduciary obligation toward his client is discharged so long as the adviser makes complete disclosure of the nature and extent of his interest.” While section 206(3) of the Investment Advisers Act of 1940 (“Act”) requires disclosure of such interest and the client's consent to enter into the transaction with knowledge of such interest, the adviser's fiduciaryduties are not discharged merely by such disclosure and consent. The adviser must have a reasonable belief that the entry of the client into the transaction is in the client's interest. The facts concerning the adviser's interest, including its level, may bear upon the reasonableness of any belief that he may have that a transaction is in a client's interest or his capacity to make such a judgment.21 [Emphasis added.]

most significant restriction upon the conduct of the firm and its personnel. At is core, the fiduciary standard of conduct restrains conduct – and deters greed. 21 Rocky Mountain Financial Planning, Inc. (pub. avail. Feb. 28, 1983) (Emphasis added.)


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It has long been the Commission’s position that the “an investment adviser must not effect transactions in which he has a personal interest in a manner that could result in preferring his own interest to that of his advisory clients.”22

Furthermore, while some commentators have advanced the argument that the Advisers Act’s purpose was “to substitute a philosophy of full disclosure for the philosophy of caveat emptor,” a closer reading of the decision reveals that this purpose was set forth as a “common” purpose of all the federal securities acts enacted in the 1930’s and in 1940. This does not lead to the conclusion that the Advisers Act’s only purpose was to require disclosure; it was merely one means by which Congress sought to protect clients of investment advisers.23 The Investment Advisers Act of 1940 goes further; it imposes fiduciary obligations upon investment advisers. Indeed, if disclosure alone were all that was required of an investment adviser when a conflict of interest was present, there would be no need for the fiduciary standard – and there would have been no pressing need for the enactment of the Advisers Act itself.

Fundamentally, the fiduciary standard of conduct changes the character of the relationship; instead of representing the product manufacturer, the fiduciary becomes the purchaser’s representative, acting on behalf of the client. The law permits the client to trust the fiduciary, as the law recognizes that the fiduciary standard of conduct is imposed in situations where public policy dictates and where disclosures are likely to be ineffective.

22 SEC Rel. No. IA-1092, October 8, 1987, 52 F.R. 38400, citing Kidder, Peabody & Co., Inc., 43 S.E.C. 911, 916 (1968). 23 Some commentators seize upon this language of the SEC vs. Capital Gains decision when they attempt to argue that disclosure of the conflict of interest is all that is required:

An investor seeking the advice of a registered investment adviser must, if the legislative purpose is to be served, be permitted to evaluate such overlapping motivations, through appropriate disclosure, in deciding whether an adviser is serving “two masters” or only one, “especially . . . if one of the masters happens to be economic self-interest.” United States v. Mississippi Valley Co., 364 U.S. 520, 549.

Yet, again, this reading of the decision is far too narrow. While certainly disclosure is one means by which the intent of Congress was effected, the avoidance of conflicts of interest is another fundamental purpose of the Advisers Act. As the U.S. Supreme Court stated in its own footnote to the passage set forth above:

This Court, in discussing conflicts of interest, has said … The reason of the rule inhibiting a party who occupies confidential and fiduciary relations toward another from assuming antagonistic positions to his principal in matters involving the subject matter of the trust is sometimes said to rest in a sound public policy, but it also is justified in a recognition of the authoritative declaration that no man can serve two masters; and considering that human nature must be dealt with, the rule does not stop with actual violations of such trust relations, but includes within its purpose the removal of any temptation to violate them....


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C. The Ineffectiveness of Disclosures: Compelling Academic Research Supports the Fiduciary Standard’s Application of the Fiduciary Duty of Loyalty

The SEC’s emphasis on disclosure, drawn from the focus of the 1933 and 1934 Securities Acts on enhanced disclosures, results from the myth that investors carefully peruse24 the details of disclosure documents that regulation delivers. However, under the scrutinizing lens of stark reality, this picture gives way to an image of a vast majority of individual investors who are unable, due to behavioral biases25 as well as a lack of knowledge of our complicated financial markets, to comprehend disclosures,26 yet alone undertake sound investment decision-making.27 As stated by former SEC Commissioner Troy A. Parades:

The federal securities laws generally assume that investors and other capital market participants are perfectly rational, from which it follows that more disclosure is always better than less. However, investors are not perfectly rational. Herbert Simon was among the first to point out that people are boundedly rational, and numerous studies have since supported Simon’s claim. Simon recognized that people have limited cognitive abilities to

24 For years it has been known that that investors do not read disclosure documents. See, generally, Homer Kripke, The SEC and Corporate Disclosure: Regulation In Search Of A Purpose (1979); Homer Kripke, The Myth of the Informed Layman, 28 Bus.Law. 631 (1973). See also Baruch Lev & Meiring de Villiers, Stock Price Crashes and 10b-5 Damages: A Legal, Economic, and Policy Analysis, 47 Stan. L. Rev. 7, 19 (1994) (“[M]ost investors do not read, let alone thoroughly analyze, financial statements, prospectuses, or other corporate disclosures ….”); Kenneth B. Firtel, Note, “Plain English: A Reappraisal of the Intended Audience of Disclosure Under the Securities Act of 1933, 72 S. Cal. L. Rev. 851, 870 (1999) (“[T]he average investor does not read the prospectus ….”). 25 For an overview of various individual investor bias such as bounded irrationality, rational ignorance, overoptimism, overconfidence, the false consensus effect, insensitivity to the source of information, the fact that oral communications trump written communications, and other heuristics and bias, see Robert Prentice, “Whither Securities Regulation? Some Behavioral Observations Regarding Proposals for its Future,” 51 Duke L. J. 1397 (2002). 26 Even a case note describing SEC vs. Capital Gains decision at the time of its issuance observed the inherent weakness of disclosures in dealing with the complex financial markets. The Supreme Court, 1963 Term—Dealing by Advisers in Recommended Securities, 78 Harv. L. Rev. 292, 294 (1964) (“If the investing public is truly naïve, disclosure does not provide a realistic method of protection.”) 27 See, e.g., Lusardi A. Financial Literacy: An Essential Tool for Informed Consumer Choice?. Dartmouth College, Harvard Business School, and National Bureau of Economic Research; 2008. [“Most individuals cannot perform simple economic calculations and lack knowledge of basic financial concepts, such as the working of interest compounding, the difference between nominal and real values, and the basics of risk diversification. Knowledge of more complex concepts, such as the difference between bonds and stocks, the working of mutual funds, and basic asset pricing is even scarcer.”]

See also, e.g., FINRA and U.S. Department of the Treasury. Financial Capability in the United States National Survey—Executive Summary. Washington, DC: United States Department of the Treasury and the FINRA Investor Education Foundation; 2009. [“In today‘s complex financial marketplace, it can take a great deal of motivation, ability, and opportunity to sort through both relevant and irrelevant data necessary to make optimal decisions. This asks a great deal of consumers, many of whom face the pressures of time poverty as well as limited financial resources. Others simply cannot or do not want to perform all the tasks needed to optimize their financial situation (i.e., set decision criteria, diligently search for information, weigh attributes, and evaluate alternatives). Furthermore, these financial decisions are highly person or household specific: one family‘s decision may not work for another. And even if consumers go through a rigorous decision-making process, there can be problems with implementation.”]


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process information. As a result, people tend to economize on cognitive effort when making decisions by adopting heuristics that simplify complicated tasks. In Simon’s terms, when faced with complicated tasks, people tend to “satisfice” rather than “optimize,” and might fail to search and process certain information.28

Nor should clients possess the obligation to achieve a sufficient state of financial literacy in order to be able to undertake sufficient judgments about securities, themselves. Financial literacy efforts, except those directed at basic financial concepts such as budgeting, savings, and the proper use of credit, are insufficient to overcome the huge knowledge gap between financial and investment advisers and their clients. This knowledge gap occurs in other professions that are also bound by a fiduciary standard of conduct. As observed by the Financial Planning Association of Australia Limited, “The average person will no more become an instant financial planner simply because of direct access to products and information than they will a doctor, lawyer or accountant.”29

The inability of clients to understand disclosures should not be underestimated. In a 2005 study:

Madrian, Choi and Laibson recruited two groups of students – MBA students about to begin their first semester at Wharton, and undergraduates (freshmen through seniors) at Harvard. All participants were asked to make hypothetical investments of $10,000, choosing from among four S&P 500 index funds. They could put all their money into one fund or divide it among two or more. ‘We chose the index funds because they are all tracking the same index, and there is no variation in the objective of the funds,’ Madrian says … ‘Participants received the prospectuses that fund companies provide real investors … the students ‘overwhelmingly fail to minimize index fund fees,’ the researchers wrote. ‘When we make fund fees salient and transparent, subjects' portfolios shift towards lower-fee index funds, but over 80% still do not invest everything in the lowest-fee fund’ … [Said Professor Madrian,] ‘What our study suggests is that people do not know how to use information well.... My guess is it has to do with the general level of financial literacy, but also because the prospectus is so long.30

28 Troy A. Parades, Blinded by the Light: Information Overload and Its Consequences for Securities Regulation, 81 Wash. Univ. L. Rev. 417, 419-9 (2003). 29 “Submission to the Financial System Inquiry by the Financial Planning Association of Australia Limited,” December 1996. 30 Knowledge@Wharton, “Today's Research Question: Why Do Investors Choose High-fee Mutual Funds Despite the Lower Returns?” citing Choi, James J., Laibson, David I. and Madrian, Brigitte C., “Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds” (March 6, 2008). Yale ICF Working Paper No. 08-14. Available at SSRN: http://ssrn.com/abstract=1125023.

The researchers updated their experiment in 2010. Choi, James, David Laibson, and Brigitte Madrian. Why does the law of one price fail? An experiment on index mutual funds. 23 Review of Financial Studies 1405 (2010) [“We asked 730 experimental subjects to each allocate a hypothetical $10,000 among four real S&P 500 index funds. All subjects received the funds’ prospectuses. To make choices incentive-compatible, subjects’ expected payments depended on the actual returns of their portfolios over a specified time period after the experimental session. We offered especially large incentives in one version of our experiment; for each of the 391 subjects in this implementation, choosing the most expensive portfolio instead of the least expensive portfolio reduced his or her wealth by $94 … no non-portfolio services were provided. Thus, the optimal portfolio allocates everything to the lowest-cost index fund … Our largest subject group (which received the largest incentives) consists of Harvard staff members—all white collar non-faculty employees – who on average have many years of experience managing their


http://ssrn.com/abstract=1125023http:information.28

Other researchers have more recently explored these behavioral biases:

Nudging investors big and small toward better decisions. Decision, 2(4), 319-326 (“Investors significantly reduce their future returns by selecting mutual funds with higher fees, allured by higher past returns that do not predict future performance. This suboptimal behavior, which can roughly halve an investor’s retirement savings, is driven by 2 psychological factors. One factor is difficulty comprehending rate information, which is critical given that mutual fund fees and returns are typically communicated in percentages. A second factor is devaluing small differences in returns or fees (i.e., a peanuts effect).”31

Another similar study came to similar conclusions:

More problematic, naïve diversification may explain a number of investment decisions that otherwise appear irrational or uninformed. For example, our study contained two index funds that were described as identical except for fees—they tracked the same index, contained the same holdings, and reported the same past performance. Overall, 74.6% of WBL participants and 65.2% of MTurk participants who invested in the low-fee index fund also invested in the high-fee index fund. Similarly, 68% of MTurk investors allocated at least some money to a higher-fee actively managed fund that was really just a closet index fund, in that its holdings and performance were identical to those reported by the index funds. This was also true of 74.1% of WBL subjects. On a somewhat different point, 79.6% of WBL and 74.1% of MTurk investors allocated at least some money to a money market fund. They did so despite the instruction to invest for a thirty-year time frame for which liquidity concerns should be minimal. Notably, the reported returns of the money market funds were significantly lower than the other fixed income alternatives …

[W]e deliberately designed our study, in contrast to other experimental studies (and the real world of investing), to make fee information simple, accessible, and comparable. Our simplification was designed to enable us to differentiate between a cognitive failure—the inability to understand fee information—and a motivational failure—indifference to fees even when the fee information is clear and available. Our results suggest that subjects who

personal finances. Furthermore, 88% have a college degree, and 60% have graduate school education as well. Our next largest group of participants consists of MBA students from Wharton. The remaining subjects are college students recruited on the Harvard campus. Our MBA subjects report an average combined SAT score of 1453, which is at the 98th percentile nationally, and our college subjects report an average score of 1499, which is at the 99th percentile. When we measure financial literacy directly, we find that all three subject groups are more knowledgeable than the typical American investor … Despite eliminating non-portfolio services, we find that almost none of the subjects minimized fees. On average, staff, MBA students, and college students respectively paid 201, 112, and 122 basis points more in fees than they needed to when they received only the funds’ prospectuses to aid their decision … Even subjects who claimed to prioritize fees in their portfolio decision showed minimal sensitivity to the fee information in the prospectus. Subjects apparently do not understand that S&P 500 index funds are commodities. In our experiment, fees paid are increasing in financial illiteracy. In the real world, this problem is likely to be exacerbated by the financial advisors whose compensation is increasing in the fees of the mutual funds they sell to their clients. When consumers in a commodity market observe prices and quality with noise, a high degree of competition will not drive markups to zero (Gabaix, Laibson, and Li, 2005; Carlin, 2009). Our results suggest that such noise helps account for the large amount of price dispersion in the mutual fund market … In sum, although better disclosure and financial education may be helpful, the evidence in this paper and Beshears et al. (2008) indicate that their effect on portfolios is likely to be modest”] Id. (Emphasis added.)00 31 Newall, P. W. S., & Love, B. C. Nudging investors big and small toward better decisions (2015), in abstract.


are not motivated to seek and use fee information will fail to do so even when cognitive barriers are minimal …

Our results with respect to both fees and diversification raise broader questions about the extent to which retail investors understand the investment process. Efficient retirement investing demands that investors understand not only basic principles of costs and diversification, but also the effect of compounding, the value of asset allocation, and the consequences of these choices for investing over a thirty-year (or longer) time horizon … Given our subjects’ expressed levels of discomfort with the investment process, we predict that, rather than attempting to understand these concepts, investors search for short-cuts, heuristics, and opportunities to delegate … Delegating responsibility for investment decisions makes investors vulnerable to the choices of professionals—choices that may be opaque, shielded from market discipline, or tainted by conflicts of interest.32

Individual investors also possess substantial confusion about mutual fund fees and costs, such as loads and 12b-1 fees.33 And many, many customers of brokers believe that the advice they receive from their broker is free.34 Simpler disclosures do not appear to make mutual fund investors more sophisticated.35

32 Jill E. Fisch & Tess Wilkinson-Ryan, Why Do Retail Investors Make Costly Mistakes? An Experiment on Mutual Fund Choice, 162 U. PA. L. REV. 605, 636-37, 643, 645 (2014). 33 See, e.g., Letter dated March 10, 2015 to Mary Jo White, Chair, SEC, from Consumer Federation of America, Americans for Financial Reform, Fund Democracy, Consumer Action, Public Citizen, and AFL-CIO (“One way that brokers obscure the costs that investors incur for their services is by charging for those services through 12b-1 fees rather than through up-front commissions. While there is nothing inherently wrong with charging for services in incremental payments, this practice suffers from several important short-comings. Because 12b-1 fees are not considered commissions, they are not subject to FINRA commission limits. Because the fees are buried within the administrative fee charged by mutual funds and annuities, investors often fail to understand how much they are paying or what they are paying for through these fees.”) Id. at p.4. 34 The Rand Report (Jan. 2008 draft) reported that 75 out of 299 respondents to a survey (as to those who answered the question posed), or nearly 25%, reported that they paid “zero” fees to their broker or investment adviser. Interestingly enough, 70% of those investors surveyed indicated that they were very satisfied with their financial services advisor. This begs the question – if the 25% who thought they were paying nothing found out the truth, would they still be very satisfied? And if the other 75% who believed they were paying some fees (but who likely were unaware of the total actual fees and costs they paid) found out the true fees and costs paid, would they be satisfied with their financial advisor?

Likewise, while a 2011 Cerulli Associates survey of 7,800 households found that 47 percent would prefer to pay commissions rather than asset-based fees (preferred by 27 percent), lump-sum retainer fees (18 percent) or hourly fees (8 percent), a large percentage of those investors (33 percent) did not know how they currently pay for investment advice, with another 31 percent believing that the advice they currently receive is free (“Commissions Win The Day Over Fees,” 2011). 35 John Beshears, James J. Choi, David Laibson, Brigitte C. Madrian, How Does Simplified Disclosure Affect Individuals’ Mutual Fund Choices? EXPLORATIONS IN THE ECONOMICS OF AGING, University of Chicago Press (2011). [“[T]he Summary Prospectus reduces the amount of time spent on the investment decision without adversely affecting portfolio quality. On the negative side, the Summary Prospectus does not change, let alone improve, portfolio choices. Hence, simpler disclosure does not appear to be a useful channel for making mutual fund investors more sophisticated and for creating competitive pricing pressure on mutual fund companies. Our experiments also shed light on the scope of investor confusion regarding loads. Even when our subjects have a one-month investment horizon— where minimizing loads is the only sensible strategy—they do not avoid loads. In our


http:sophisticated.35http:interest.32

Other investor biases overwhelm the effectiveness of disclosures. As stated by Professor Fisch:

The primary difficulty with disclosure as a regulatory response is that there is limited evidence that disclosure is effective in overcoming investor biases. … It is unclear … that intermediaries offer meaningful investor protection. Rather, there is continued evidence that broker-dealers, mutual fund operators, and the like are ineffective gatekeepers. Understanding the agency costs and other issues associated with investing through an intermediary may be more complex than investing directly in equities ….”36

Many other academic studies in recent years indicate the ineffectiveness of disclosures given the substantial behavioral biases individuals possess, as well as the perverse effects of disclosures upon providers of services.37 For example:

Cain, Loewenstein, and Moore (2011) suggest that receiving unbiased advice in addition to (disclosed) biased advice can help ameliorate inadequate discounting of conflicted advice ... The empirical evidence on disclosure suggests that in isolation it may be ineffective and could actually exacerbate problems arising from conflicts of interest. Without other intervention, disclosure has been found to make advisors more comfortable in inflating their recommendations (Cain, Loewenstein, and Moore, 2005), increasing pressure on advisees to comply with advice

experiment, subjects chose funds with an average load of 3.00 percent in the conditions with an investment horizon of one month. This choice is like betting that the chosen portfolio has an (implausible) excess log return relative to the load- minimizing portfolio of 24 percentage points per year. We conclude that our subjects either do not understand how loads work or do not take them into account. We also conclude that the Summary Prospectus does nothing to alleviate these kinds of errors.”] Id. 36 Jill E. Fisch, “Regulatory Responses To Investor Irrationality: The Case Of The Research Analyst,” 10 Lewis & Clark L. Rev. 57, 74-83 (2006). 37 See, e.g., George Loewenstein, Cass R. Sunstein, and Russell Golman, Disclosure: Psychology Changes Everything, 6 Annu. Rev. Econ. 391 (2014) [“Psychological factors severely complicate the standard arguments for the efficacy of disclosure requirements. Because attention is both limited and motivated, disclosures may be ignored, especially if they are complex and provide unwelcome news, and new disclosures, even of valid information, may turn out to distract attention from older and possibly more important ones. As a result of limited attention and the other psychological factors discussed in Section 3, disclosure requirements appear to have been less effective in changing recipient behavior than their proponents seem to assume … Unfortunately, disclosure of misaligned incentives can have perverse effects on the producer side of the equation. Specifically, advisors who would have otherwise been intrinsically motivated to provide unbiased advice can feel morally licensed to provide biased advice once a conflict of interest has been disclosed. And because of insinuation anxiety, advice recipients may feel greater pressure, with this disclosure, to follow the now less trusted advice.” Id. at 413-4.

A study conducted by the Australian Securities & Investment Commission in 2006 found that advisors were six times more likely to offer “bad advice” (advice that was subjectively determined not to have considered key factual issues, did not fit the client’s needs, or was likely to leave the client worse off) when the advisor had a conflict of interest over compensation (e.g., commissions) and three times more likely when suggesting an associated product (e.g., an in-house fund). The study also found that consumers were rarely able to detect bad advice.

See also Carmel, Eyal and Carmel, Dana and Leiser, David and Spivak, Avia, Facing a Biased Adviser While Choosing a Retirement Plan: The Impact of Financial Literacy and Fair Disclosure. (July 9, 2015). [“The aim of the present study was to explore the effect of the advice given by the agent, along with that of two further factors: a fair disclosure statement regarding the agent’s conflict of interest, and the customer's degree of financial literacy. Two experiments conducted among undergraduate students in Israel showed that customers mostly follow the agent's recommendation, even against their best interest, and despite the presence of a fair disclosure statement.”]


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(Loewenstein, Cain, Sah, 2011; Sah, Loewenstein and Cain, 2013), and confusing recipients when the information disclosed is not representative of objectivity (Dopuch, King, Schwartz, 2003). Additionally, people with low levels of financial literacy or who are anxious (Gino, Brooks, and Schweitzer, 2012) may not pay sufficient attention to the information that is disclosed.38

The inadequacy of disclosures was known even in 1930’s. Even back during the consideration of the initial federal securities laws, the perception existed that disclosures would prove to be inadequate as a means of investor protection. As stated by Professor Schwartz:

Analysis of the tension between investor understanding and complexity remains scant. During the debate over the original enactment of the federal securities laws, Congress did not focus on the ability of investors to understand disclosure of complex transactions. Although scholars assumed that ordinary investors would not have that ability, they anticipated that sophisticated market intermediaries – such as brokers, bankers, investment advisers, publishers of investment advisory literature, and even lawyers - would help filter the information down to investors.39

A growing body of academic research into the behavioral biases of investors reveals substantial obstacles individual investors must overcome in order to make informed decisions,40 and reveal the inability of individual investors to contract for their own protections.41

38 Jeremy Burke, Angela A. Hung, Jack Clift, Steven Garber, and Joanne K. Yoong, Impacts of Conflicts of Interest in the Financial Services Industry (RAND working paper, Feb. 2015), at pp. 39-40. 39 Steven L. Schwarcz, Rethinking The Disclosure Paradigm In A World Of Complexity, Univ. Ill. L. Rev Vol. 2004, p.1, 7 (2004), citing “Disclosure To Investors: A Reappraisal Of Federal Administrative Policies Under The ‘33 and ‘34 Acts (The Wheat Report),“ 52 (1969); accord William O. Douglas, “Protecting the Investor,” 23 Yale Rev. 521, 524 (1934). 40 As stated by Professor Ripken: “[E]ven if we could purge disclosure documents of legaleze and make them easier to read, we are still faced with the problem of cognitive and behavioral biases and constraints that prevent the accurate processing of information and risk. As discussed previously, information overload, excessive confidence in one’s own judgment, overoptimism, and confirmation biases can undermine the effectiveness of disclosure in communicating relevant information to investors. Disclosure may not protect investors if these cognitive biases inhibit them from rationally incorporating the disclosed information into their investment decisions. No matter how much we do to make disclosure more meaningful and accessible to investors, it will still be difficult for people to overcome their bounded rationality. The disclosure of more information alone cannot cure investors of the psychological constraints that may lead them to ignore or misuse the information. If investors are overloaded, more information may simply make matters worse by causing investors to be distracted and miss the most important aspects of the disclosure … The bottom line is that there is ‘doubt that disclosure is the optimal regulatory strategy if most investors suffer from cognitive biases’ … While disclosure has its place in a well-functioning securities market, the direct, substantive regulation of conduct may be a more effective method of deterring fraudulent and unethical practices.” Ripken, Susanna Kim, The Dangers and Drawbacks of the Disclosure Antidote: Toward a More Substantive Approach to Securities Regulation. Baylor Law Review, Vol. 58, No. 1, 2006; Chapman University Law Research Paper No. 2007-08. Available at SSRN: http://ssrn.com/abstract=936528. 41 See Robert Prentice, Whither Securities Regulation Some Behavioral Observations Regarding Proposals for its Future, 51 Duke Law J. 1397 (March 2002). Professor Prentices summarizes: “Respected commentators have floated several proposals for startling reforms of America’s seventy-year-old securities regulation scheme. Many involve substantial deregulation with a view toward allowing issuers and investors to contract privately for desired levels of disclosure and fraud protection. The behavioral literature explored in this Article cautions that in a deregulated securities world it is exceedingly optimistic to expect issuers voluntarily to disclose optimal levels of


http://ssrn.com/abstract=936528http:protections.41http:investors.39http:disclosed.38

Moreover, the perverse effects of disclosure have been noted. Rather than improving the quality of investment advice provided, disclosures of conflict of interest often result in worse advice being provided, as this study pointed out:

Conflicts of interest can lead experts to give biased and corrupt advice. Although disclosure is often proposed as a potential solution to these problems, we show that it can have perverse effects. First, people generally do not discount advice from biased advisors as much as they should, even when advisors’ conflicts of interest are honestly disclosed. Second, disclosure can increase the bias in advice because it leads advisors to feel morally licensed and strategically encouraged to exaggerate their advice even further. As a result, disclosure may fail to solve the problems created by conflicts of interest and may sometimes even make matters worse.42

information, securities intermediaries such as stock exchanges and stockbrokers to appropriately consider the interests of investors, or investors to be able to bargain efficiently for fraud protection.” Available at http://www.law.duke.edu/shell/cite.pl?51+Duke+L.+J.+1397. 42 Cain, Daylian M., Loewenstein, George, and Moore, Don A., “The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest”(2003).

See also Argandoña, Antonio, Conflicts of Interest: The Ethical Viewpoint. IESE Business School Working Paper No. 552, stating:

As a rule, we tend to assume that competent, independent, well trained and prudent professionals will be capable of making the right decision, even in conflict of interest situations, and therefore that the real problem is how to prevent conscious and voluntary decisions to allow one’s own interests (or those of third parties) to prevail over the legitimate interests of the principal – usually by counterbalancing the incentives to act wrongly, as we assume that the agents are rational and make their decisions by comparing the costs and benefits of the various alternatives. Beyond that problem, however, there are clear, unconscious and unintended biases in the way agents gather, process and analyze information and reach decisions that make it particularly difficult for them to remain objective in these cases, because the biases are particularly difficult to avoid. It has been found that,

• The agents tend to see themselves as competent, moral individuals who deserve recognition.

• They see themselves as being more honest, trustworthy, just and objective than others. • Unconsciously, they shut out any information that could undermine the image they have

of themselves – and they are unaware of doing so. • Also unconsciously, they are influenced by the roles they assume, so that their preference

for a particular outcome ratifies their sense of justice in the way they interpret situations. • Often, their notion of justice is biased in their own favor. For example, in experiments in

which two opposed parties’ concept of fairness is questioned, both tend to consider precisely what favors them personally, even if disproportionately, to be the most fair.

• The agents are selective when it comes to assessing evidence; they are more likely to accept evidence that supports their desired conclusion, and tend to value it uncritically. If evidence contradicts their desired conclusion, they tend to ignore it or examine it much more critically.

• When they know that they are going to be judged by their decisions, they tend to try to adapt their behavior to what they think the audience expects or wants from them.

• The agents tend to attribute to others the biases that they refuse to see in themselves; for example, a researcher will tend to question the motives and integrity of another researcher who reaches conclusions that differ from her own.


http://www.law.duke.edu/shell/cite.pl?51+Duke+L.+J.+1397http:worse.42

Note as well that “instead of leading investors away from their behavioral biases, financial professionals may prey upon investors’ behavioral quirks … Having placed their trust in their brokers, investors may give them substantial leeway, opening the door to opportunistic behavior by brokers, who may steer investors toward poor or inappropriate investments.”43 Moreover, “not only can marketers who are familiar with behavioral research manipulate consumers by taking advantage of weaknesses in human cognition, but … competitive pressures almost guarantee that they will do so.”44 Indeed, many brokers and other financial advisors have received training, time and again, stressing the need to first and foremost establish a relation of trust and confidence with the client; after trust is established, it is taught that the client usually defers to the judgment of the advisor as to recommendations made, usually without further inquiry by the client, thereby permitting the financial advisor to take advantage of the client.

There is no doubt that financial services professionals desire to gain the trust of their customers and clients. But the acquisition of the trust of a customer or client should carry with it the full application of the fiduciary standard of conduct. Engagement in trust-based sales activities, without concurrent imposition of fiduciary standards, can result to wholesale harm to individual investors, as alluded to by Professor Langevoort, who undertook these observations regarding “trust-based selling”:

[W]hen faced with complex, difficult and affect-laden choices (and hence a strong anticipation of regret should those choices be wrong), many investors seek to shift responsibility for the investments to others. This is an opportunity – the core of the full-service brokerage business – to use trust-based selling techniques, offering advice that customers sometimes too readily accept. Once trust is induced, the ability to sell vastly more complicated, multi-attribute investment products goes up. Complex products that have become widespread in the retail sector, like equity index annuities, can only be sold by intensive, time-consuming sales effort. As a result the sales fees (and embedded incentives) are very large, creating the temptation to oversell. In the mutual fund area, the broker channel – once again, driven by generous incentives - sells funds aggressively. Recent empirical research suggests that buyers purchase funds in this channel at much higher cost but performance on average is no better, and often worse, than readily available no-load funds.45

• Generally speaking, the agents tend to give far more importance to other people’s predispositions and circumstances than to their own.

For all these reasons, agents, groups and organizations believe that they are capable of identifying and resisting the temptations arising from their own interests (or from their wish to promote the interests of others), when the evidence indicates that those capabilities are limited and tend to be unconsciously biased.

Id. at pp. 6-7. 43 Stephen J. Choi and A.C. Pritchard, “Behavioral Economics and the SEC” (2003), at p.18. 44 Robert Prentice, “Contract-Based Defenses In Securities Fraud Litigation: A Behavioral Analysis,” 2003 U.Ill.L.Rev. 337, 343-4 (2003), citing Jon D. Hanson & Douglas A. Kysar, “Taking Behavioralism Seriously: The Problem of Market Manipulation,” 74 N.Y.U.L.REV. 630 (1999) and citing Jon D. Hanson & Douglas A. Kysar, “Taking Behavioralism Seriously: Some Evidence of Market Manipulation,” 112 Harv.L.Rev. 1420 (1999). 45 Donald C. Langevoort, “The SEC, Retail Investors, and the Institutionalization of the Securities Markets” (Jan. 2009), prior version available at vailable at SSRN: http://ssrn.com/abstract=1262322.


http://ssrn.com/abstract=1262322http:funds.45

D. The Problem of Shedding the Fiduciary Hat: Dual Registrants

While the issue of the duties of dual registrants was not addressed at length in the Commission’s proposed interpretation, the issues relating to dual registration are many. I submit that the Commission should re-visit the issue of dual registrant, by requiring investment advisers to not be able to take off the “fiduciary hat” (i.e., no “hat-switching”) with respect to the same client. Nor should an investment adviser be relieved of her or his fiduciary obligations as to some of the accounts of a client (i.e., no wearing of “two hats” – one for each account).

Time and again our courts have enumerated the fiduciary maxim: “No man can serve two masters.”46 As stated early on by the U.S. Supreme Court: “The two characters of buyer and seller are inconsistent: Emptor emit quam minimo potest, venditor vendit quam maximo potest.”47

The ineffectiveness of disclosures, discussed in the prior section, extends to situations in which a dual registrant seeks to change her or his status from that of a fiduciary to a non-fiduciary. It is highly doubtful that, even with disclosure and consent, the client understands and appreciates the ramifications of such a change in status.48

Furthermore, the Commission recognized, long ago, that trust-based selling – such as the preparation of comprehensive financial plans as a means to gain the trust of the client – should result in the imposition of fiduciary status for the entirety of the relationship. Indeed, the use of financial planning services as a means to sell securities in order to generate profits by brokers was criticized early on by the Commission:

Between May 1960 and June 1964, registrant, together with or willfully aided and abetted by Hodgdon, Haight, Carr, Adam, Harper, Kitain, Davis and Kibler, engaged in a scheme to defraud customers who utilized registrant's financial planning services in the purchase and sale of securities, in willful violation of Section 17(a) of the Securities Act of 1933 and Sections 10(b) and 15(c)(l) of the Exchange Act and Rules 10b-5 and 15c1-2 thereunder. The record shows that the gist of the scheme was respondents' holding themselves out as financial planners who would

46 See, e.g., Carter v. Harris, 25 Va. 199; 1826 Va. LEXIS 26; 4 Rand. 199 (Va. 826) (“It is well settled as a general principle, that trustees, agents, auctioneers, and all persons acting in a confidential character, are disqualified from purchasing. The characters of buyer and seller are incompatible, and cannot safely be exercised by the same person. Emptor emit quam minimo potest; venditor vendit quam maximo potest. The disqualification rests, as was strongly observed in the case of the York Buildings Company v. M'Kenzie, 8 Bro. Parl. Cas. 63, on no other than that principle which dictates that a person cannot be both judge and party. No man can serve two masters. He that it interested with the interests of others, cannot be allowed to make the business an object of interest to himself; for, the frailty of our nature is such, that the power will too readily beget the inclination to serve our own interests at the expense of those who have trusted us.”). Id. at 204. 47 Wormley v. Wormley, 21 U.S. 421; 5 L. Ed. 651; 1823 U.S. LEXIS 290; 8 Wheat. 421 (1823). See also Michoud v. Girod, 45 U.S. 503; 11 L. Ed. 1076; 1846 U.S. LEXIS 412; 4 HOW 503 (1846) (“[I}f persons having a confidential character were permitted to avail themselves of any knowledge acquired in that capacity, they might be induced to conceal their information, and not to exercise it for the benefit of the persons relying upon their integrity. The characters are inconsistent. Emptor emit quam minimo potest, venditor vendit quam maximo potest.”] 48 See, e.g., Frankel, Tamar, Fiduciary Duties as Default Rules, 74 Or. L. Rev. 1209. (“The “voluntariness of an apparent consent to an unfair transaction could be a lingering suspicion that generally, when entrustors consent to waive fiduciary duties (especially if they do not receive value in return) the transformation to a contract mode from a fiduciary mode was not fully achieved. Entrustors, like all people, are not always quick to recognize role changes, and they may continue to rely on their fiduciaries, even if warned not to do so.”)


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exercise their talents to make the best choices for their clients from all available securities, when in fact their efforts were directed at liquidating clients' portfolios and utilizing the proceeds and their clients' other assets to purchase securities which would yield respondents the greatest profits, in some instances in complete disregard of their clients' stated investment objectives. This scheme was implemented by, among other things, registrant's advertising and by its training course for salesmen …

It is abundantly clear from this record that under the guise of comprehensive "financial planning" encompassing the purchase of varied securities, including listed securities, the above respondents induced customers, who were generally inexperienced and unsophisticated, to believe that their best interests would be served by following the investment program designed for them by respondents. In fact, such programs were designed to sell securities that would provide the greatest gain to respondents, rather than to promote the customers' interests; indeed, in some instances, the recommendations were directly contrary to the customers' expressed investment needs and objectives.49

The Commission long ago recognized that dual interests should not exist. For example, the Commission opined that the receipt of soft dollars by a dual registrant would be inappropriate if the client was not credited:

Because the advisory clients' commission dollars generate soft dollar credits, soft dollar benefits are the assets of the clients. 50

The difficulties of reconciling fiduciary duties when dual interests are to be served has not gone unnoticed by other commentators and jurists over the many years in which fiduciary principles have been applied. For example, long ago Chief Justice Harlan Stone noted:

I venture to assert that when the history of the financial era which has just drawn to a close comes to be written, most of its mistakes and its major faults will be ascribed to the failure to observe the fiduciary principle, the precept as old as holy writ, that ‘a man cannot serve two masters.’51

Justice Shientag of the New York Supreme Court also noted the rationale against permitting a person to serve dual interests:

While there is a high moral purpose implicit in this transcendent fiduciary principle of undivided loyalty, it has back of it a profound understanding of human nature and of its frailties. It actually accomplishes a practical, beneficent purpose. It tends to prevent a clouded conception of fidelity that blurs the vision. It preserves the free exercise of judgment uncontaminated by the dross of divided allegiance or self-interest. It prevents the operation of an influence that may be indirect but that is all the more potent for that reason.52

49 In the Matter of Haight & Company, Inc. (Feb. 19, 1972). 50 In the Matter of Haight & Company, Inc. (Feb. 19, 1972). This prior rule likes in stark contrast with current requirements of the Commission. 51 Harlan Stone (future Chief Justice of the U.S. Supreme Court), The Public Influence of the Bar (1934) 48 Harv. L.Rev. 1, 8-9. 52 Bayer v. Beran, 49 N.Y.S.2d 2, citing see Republic New York Securities Corp., Advisers Act Rel. No. 1789, 1999 SEC LEXIS 278 (February 10, 1999).


http:N.Y.S.2dhttp:reason.52http:objectives.49

And, in a decision over 180 years old, the dangers of dual interests were clearly stated, as was the remedy (the avoidance of dual interests by a continuance of fiduciary status across the relationship):

The temptation of self interest is too powerful and insinuating to be trusted. Man cannot serve two masters; he will foresake the one and cleave to the other. Between two conflicting interests, it is easy to foresee, and all experience has shown, whose interests will be neglected and sacrificed. The temptation to neglect the interest of those thus confided must be removed by taking away the right to hold, however fair the purchase, or full the consideration paid; for it would be impossible, in many cases, to ferret out the secret knowledge of facts and advantages of the purchaser, known to the trustee or others acting in the like character. The best and only safe antidote is in the extraction of the sting; by denying the right to hold, the temptation and power to do wrong is destroyed.”53

Fiduciary is a status relation that results, in the arena of financial planning and investments, from an undertaking54 to provide advice to a client. And fiduciary status, under the common law, extends across the entirety of the relationship.55

Investment advisers are (or, at least, should be) professionals.56 They possess professional obligations to their clients. A fundamental characteristic of a profession is that its members agree to certain

53 Thorp v. McCullum, 1 Gilman (6 Ill.) 614, 626 (1844). 54 See, e.g., James Edelman, The Role of Status in the Law of Obligations: Common Callings, Implied Terms and Lessons for Fiduciary Duties (2013), stating: “In Australia, in the leading Australian formulation of the fiduciary duty, Mason J explained that the 'critical' feature of fiduciary relationships was that the fiduciary 'undertakes or agrees to act for or on behalf of or in the interests of another person in the exercise of a power or discretion which will affect the interests of that other person in a legal or practical sense.’ … The same is true in Canada … the Supreme Court of Canada said of fiduciary duties in equity that '[i]t is fundamental to all ad hoc fiduciary duties that there be an undertaking by the fiduciary, which may be either express or implied, that the fiduciary will act in the best interests of the other party….” Id. at text surrounding fn. 21-24 (Citations omitted.) 55 A fiduciary is in a relationship with the entrustor. See, e.g., Edward P. Richards and Katharine C. Rathburn, LAW AND THE PHYSICIAN (1993), “The physician-patient relationship is a member of a special class of relationships called fiduciary relationships.” (Emphasis in original.)

Once in the relationship, fiduciary status extends across all aspects of that relationship. See David Glusman, Gabriel Ciociola, ACCOUNTANTS’ ROLES AND RESPONSIBILITIES IN ESTATES AND TRUSTS (2009), stating in pertinent part, and in the context of trustees, that the “relationship is one where the beneficiary is able to rely on the fiduciary with confidence and trust. Further still, the fiduciary is required to act with unquestioned good faith, always maintaining the best interests of the beneficiary even over his or her personal interests. A fiduciary’s duty extends to all aspects of financial and related operations.”

The Certified Financial Planner Board of Standards, Inc. recently adopted a new “Code of Ethics and Standards of Conduct,” effective October 1, 2019, that essentially provides that the fiduciary standard of conduct applies to all aspects of the financial planning and investment relationship with the client. “The new Code and Standards includes a range of important changes, including expanding the application of the fiduciary standard that requires CFP® professionals to act in the best interest of the client at all times when providing financial advice.” CFP Board web site, “New Code of Ethics and Standards of Conduct” page (retrieved Aug. 4, 2018). 56 Early on, Douglas T. Johnston, Vice President of the Investment Counsel Association of America, stated in part: ‘The definition of 'investment adviser' … include[s] those firms which operate on a professional basis and which have come to be recognized as investment counsel.” Lowe v. SEC, 472 U.S. 181 (1985), fn. 38. [Emphasis added.] Moreover,


http:professionals.56http:relationship.55

restrictions upon their conduct. When the fiduciary mantle has been assumed with respect to a client, the investment adviser’s fiduciary status should properly extend to the entirety of the relationship with that client.

E. Correctly Applying the Fiduciary Standard of Conduct Requires an Understanding of the Important Public Policy Rationale that Supports the Application of Fiduciary Principles

The key to understanding fiduciary principles, and why and how they are applied, rests in discerning the various public policy objectives the fiduciary standard of conduct is designed to meet.

(1) Fiduciary Status Addresses “Overreaching” When Person-To-Person Advice Is Provided

The Investment Advisers Act of 1940 “recognizes that, with respect to a certain class of investment advisers, a type of personalized relationship may exist with their clients … The essential purpose of [the Advisers Act] is to protect the public from the frauds and misrepresentations of unscrupulous tipsters and touts and to safeguard the honest investment adviser against the stigma of the activities of these individuals by making fraudulent practices by investment advisers unlawful.”57 “The Act was designed to apply to those persons engaged in the investment-advisory profession -- those who provide personalized advice attuned to a client's concerns, whether by written or verbal communication58 … The dangers of fraud, deception, or overreaching that motivated the enactment of the statute are present in personalized communications ….”59

(2) Consumers’ Lack Of Desire To Expend Time And Resources On Monitoring

The inability of clients to protect themselves while receiving guidance from a fiduciary does not arise solely due to a significant knowledge gap or due to the inability to expend funds for monitoring of the fiduciary. Even highly knowledgeable and sophisticated clients (including many financial institutions) rely

the U.S. Securities and Commission’s report which led to the adoption of the Advisers Act “stressed the need to improve the professionalism of the industry, both by eliminating tipsters and other scam artists and by emphasizing the importance of unbiased advice, which spokespersons for investment counsel saw as distinguishing their profession from investment bankers and brokers.” Commission Staff, “Study on Investment Advisers and Broker Dealers” (Jan. 21, 2011), citing Investment Trusts and Investment Companies: Investment Counsel, Investment Management, Investment Supervisory, and Investment Advisory Services, H.R. Doc. No. 477 at 27-30 (1939). [Emphasis added.] However, some of the hallmarks of a profession do not exist for investment advisers. For example, some authorities regard substantial higher education, such as a four-year college degree in which a specialized course of study is pursued relating to the activities to be pursued, as a necessary precondition for recognition of a profession.

The need for professional status, and the concurrent restraints on conduct that flow therefrom, was even recognized by Adam Smith the founder of modern capitalism: “Our continual observations upon the conduct of others insensibly lead us to form to ourselves certain general rules concerning what is fit and proper either to be done or to be avoided.” Adam Smith, THE THEORY OF MORAL SENTIMENTS at p.229 (E.G. West ed. 1969). 57 Lowe v. SEC, 472 U.S. 181, 200, 201 (1985). 58 Id. at 208. 59 Id. at 210.


upon fiduciaries. While they may possess the financial resources to engage in stringent monitoring, and may even possess the requisite knowledge and skill to undertake monitoring themselves, the expenditure of time and money to undertake monitoring would deprive the investors of time to engage in other activities. Indeed, since sophisticated and wealthy investors have the ability to protect themselves, one might argue they might as well manage their investments themselves and save the fees. Yet, reliance upon fiduciaries is undertaken by wealthy and highly knowledgeable investors and without expenditures of time and money for monitoring of the fiduciary. In this manner, “fiduciary duties are linked to a social structure that values specialization of talents and functions.”60

(3) The Shifting Of Monitoring Costs To Government

In service provider relationships which arise to the level of fiduciary relations, it is highly costly for the client to monitor, verify and ensure that the fiduciary will abide by the fiduciary’s promise and deal with the entrusted power only for the benefit of the client. Indeed, if a client could easily protect himself or herself from an abuse of the fiduciary advisor’s power, authority, or delegation of trust, then there would be no need for imposition of fiduciary duties. Hence, fiduciary status is imposed as a means of aiding consumers in navigating the complex financial world, by enabling trust to be placed in the advisor by the client.

Fiduciary relationships are relationships in which the fiduciary provides to the client a service that public policy encourages. When such services are provided, the law recognizes that the client does not possess the ability, except at great cost, to monitor the exercise of the fiduciary’s powers. Usually the client cannot afford the expense of engaging separate counsel or experts to monitor the c

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SEC vs. Capital Gains · 2018. 8. 6. · I provide these comments from my perspective as an attorney-at-law (estate planning, taxation) for 32 years, a registered investment adviser